Central Banks’ Quasi-Fiscal Deficits and Potential Hyperinflation


There are different discussions ongoing if a central bank may monetize debt and act of a quasi-fiscal agent. One opinion was the Modern Monetary Theory that advocates monetizing debt and these quasi-fiscal deficits. We will discuss here  the moderate view and the opposite view , namely that monetizing debt may lead to hyperinflation.

A moderate view comes from Willem Buiter in the year 2009 via the FT .
Should central banks be quasi-fiscal actors?

There are two reasons why the Fed, or any other central bank, should not act as a quasi-fiscal branch of the government, other than paying to the Treasury in taxes the profits it makes in the pursuit of its mandated macroeconomic stability objectives (maximum employment, stable prices and moderate long-term interest rates in the case of the Fed) and its appropriate financial stability objectives.  The appropriate financial stability objectives of the central bank are those that involve providing liquidity, at a cost covering the central bank’s opportunity cost of non-monetary financing, to illiquid but solvent financial institutions.

Any action going beyond that, such as the recapitalisation of insolvent banks through quasi-fiscal subsidies, ought to be funded by the Treasury.  The central bank should be involved only as an agent of the Treasury – an expert assistant.  It should not put its own conventional or comprehensive balance sheet at risk.

The two arguments against the central bank acting as a quasi-fiscal agent are, first, that acting as a quasi-fiscal agent may impair the central bank’s ability to fulfil its macroeconomic stability mandate and, second, that it obscures responsibility and impedes accountability for what are in substance fiscal transfers.

The following is the full academic theoretical background by Willem Buiter that emphasizes the importance of the seigniorage effect as advantage for the central bank.

In a severe form quasi-fiscal deficits can lead to hyperinflation. In our view it  can only happen when a country is severely dependent of foreign inflows or is obliged to heavy war reparations like Germany in 1923. Examples for the dependency of heavy inflows are Zimbabwe but also countries like Brazil or India. The following Wordbank papers look after quasi-fiscal deficits and hyperinflation case in the 1990s for:
CIS countries

Most recently the central bank of Kazakhstan devalued its currency by 19%, exactly to prevent such pseudo-fiscal deficits.
The United States is dependent on foreign inflows, but (still) has high wealth compared to other nations. Moreover, it has the world reserve currency status which guarantees inflows in particular thanks to trade surpluses of emerging markets (EM) that hedge against the hyperinflation scenario we are discussing using US treasury bonds.

Recently this formerly big EM trade surplus has gone to zero. US treasuries yield near to 3%, while the supposed “risky” bonds of Spain or Italy are less expensive than US bonds. Therefore we doubt that the currently huge European trade surplus bounces back into the United States, and this represents a risk for the U.S.


The view monetizing debt and quasi-fiscal deficits may lead to hyperinflation comes from the Austrian Mises institute.


Submitted by Martin Sibileau of A View From The Trenches blog,

What causes hyperinflations? The answer is: Quasi-fiscal deficits! Why have we not seen hyperinflation yet? Because we have not had quasi-fiscal deficits!


As anticipated in my previous letter, today I want to discuss the topic of high or hyperinflation: What triggers it? Is there a common feature in hyperinflations that would allow us to see one when it’s coming? If so, can we make an educated guess as to when to expect it? The analysis will be inductive (breaking with the Austrian method) and in the process, I will seek to help Peter Schiff find an easy answer to give the media whenever he’s questioned about hyperinflation. If my thesis is correct, three additional conclusions should hold: a) High inflation and high nominal interest rates are not incompatible but go together: There cannot be hyperinflation without high nominal interest rates, b) The folks at the Gold Anti-Trust Action Committee will eventually be out of a job, and c) Jim Rogers will have been proved wrong on his recommendation to buy farmland.

(Before we deal with these questions, a quick note related to my last letter: A friend pointed me to this article in Zerohedge.com, where the problem on liquidity being diverted back to shareholders in the form of share buybacks and dividends was exposed, before I would bring it up, on my letter of March 4th. )
A forensic analysis on dead currencies

When I think of hyperinflation, I think of dead currencies. They are the best evidence. There is a common pattern to be found in every one of them and no, I am not talking of six-to-eight-figure denomination bills or shortages of goods. These are just symptoms. Behind the death of every currency in modern times, there has been a quasi-fiscal deficit causing it. Thus, briefly, when someone asks: What causes hyperinflations? The answer is: Quasi-fiscal deficits! Why have we not seen hyperinflation yet? Because we have not had quasi-fiscal deficits!
What is a quasi-fiscal deficit?

A quasi-fiscal deficit is the deficit of a central bank. From Germany to Argentina to Zimbabwe, the hyper or high inflationary processes have always been fueled by such deficits. Monetized fiscal deficits produce inflation. Quasi-fiscal deficits (by definition, they are monetized) produce hyperinflation. Remember that capital losses due to the mark down of assets do not affect central banks: They simply don’t need to mark to market. They mark to model.

The only losses that can meaningfully affect central banks stem from flows (i.e. deficits), like net interest losses. These losses result from paying a higher interest on their (i.e. central banks’) liabilities than what they receive from their assets. These losses leave central banks no alternative but to monetize them, in a deadly feedback loop. They are like black holes: Once trapped into them, there is no way out, because (fiscal) spending cuts are no longer relevant, unless they produce a surplus material enough to offset the quasi-fiscal deficits. And that, by definition, is impossible.

This raises questions like: Why would a central bank need to pay interest on its liabilities? Why would the monetization of the losses necessarily lead to a spiralling process?

currently pictures are not available from Martin’s site, to be fixed

Why would a central bank need to pay interest on its liabilities?

Why would a central bank need to pay interest on its liabilities?

This is a key point to understand inflation. According to mainstream economists, inflation is a process that pops once the potential output gap of a currency zone is eliminated. Inflation is the consequence of reaching full employment of resources, they say, and place the situation within the context of “hydraulics”.  In the figure below, I illustrate this context, showing two glasses: One is not full, and therefore, there should not be inflationary pressures.

[Dec 16 2012 2] currently pictures are not available from Martin’s site, to be fixed

Please, do not laugh at the figure. It also contains a citation from a speech given by Fed’s Governor Jeremy C. Stein a few months ago, that uses this same metaphor to illustrate how the Fed thinks about their policies. If it wasn’t so sad, it would be comic. And it is sad because there is absolutely no historical evidence of a nation sustainably living under inflation that would have reached full employment. In fact, it is quite the opposite: Inflation breeds unemployment, which breeds shortages and further inflation. This is why this whole situation is so sad. Millions of lives have been and will continue to be ruined because of this error.

The truth is however that inflation and financial repression are inseparable. They are different faces of the same coin, and as inflation develops, financial repression morphs into plain confiscation. As at December 2012, we have only had increasing financial repression, mostly in the form of price manipulation. Some of this manipulation is open, as with interest rates, and some of it is covered, as with gold, the consumer price index or the unemployment rate. But as the US fiscal deficits grows, the manipulation will be increasingly open and the fear of confiscation will be very tangible. Yes, the manipulation will be so open that even the GATA (Gold Anti-Trust Action Committee) will completely lose its raison d’être. It will be worthless to expose what will be public.

With regards to the fear of confiscation, there is a good example in the drop in deposits from the banks in the periphery of the Euro zone. Any rational investor could see that his bank was being coerced into purchasing the worthless debt of its sovereign and that the likelihood of being caught in a bank run was exponentially rising. Policy makers in the Euro zone chose not to confiscate. It was too early to do so, in the presence of other alternatives. But deposits dropped nevertheless, and to restore them, the European Central Bank will have to pay higher interest rates on its sterilized purchases, when it finally engages in Open Monetary Transactions (i.e. purchase of sovereign debt with maturity under three years). I explained this in September: Since the backstop of the ECB removes jump-to-default risk from the front end (i.e. 1 to 3 years, in sovereign debt), selling the sovereign debt to the central bank for cash will be a losing proposition for banks. The Euro zone banks will demand that the purchases be sterilized, to receive central bank debt in exchange and at an acceptable interest rate. This rate will have to be higher than it currently is. This is why, in my opinion, we are seeing a stronger Euro and weaker Treasuries.
Why would a government want to maintain a certain level of deposits?

Governments need bank deposits to fund the bonds they force their banks to buy. The regulations, the pressure on the bankers, the open threats are all part of the same means to coerce bankers to fund their debts with your savings. Is this what was behind the failed moves in 2012 to destroy the US money market funds?

Essentially, hyperinflation is the ultimate and most expensive bailout of a broken banking system, which every holder of the currency is forced to pay for in a losing proposition, for it inevitably ends in its final destruction. Hyperinflation is the vomit of economic systems: Just like any other vomit, it’s a very good thing, because we can all finally feel better. We have puked the rotten stuff out of the system.
Why would depositors not want to renew deposits?

Whenever the weight of deficits passes a certain milestone, people begin to flee en masse from the system. They not only take their savings from the system, but they generate income outside it too. This has happened since times immemorial. Below is a picture of buried coins, found in Hertfordshire. They are presumed to have been hoarded in 4th century during the final years of Roman rule.

Then and now, the tax pressure ended breaking capital markets and trade. In the early stages, everyone seeks to stop investing and collect by any means whatever capital that can be recovered. Nobody should be surprised if, with thes

Then and now, the tax pressure ended breaking capital markets and trade. In the early stages, everyone seeks to stop investing and collect by any means whatever capital that can be recovered. Nobody should be surprised if, with these low interest rates, the wave of share buybacks and dividend payments increases. The shrinkage of the system exacerbates the fall in tax revenue and the intervention of central banks, leading to the self fulfilling outcome of quasi-fiscal deficits. Production falls and the shortage of goods, together with the increase in the circulation of money, triggers high inflation. Price controls follow.

If this is correct, Jim Rogers is wrong and you should not buy farmland. Farming will not be profitable. The increase in food prices would not be a signal to encourage farming, but the reflection of the fact that farming is not profitable because it is easy to tax. Hence, the food shortages. The same applies to real estate in general, as the rule of the mob spreads and the rights of debtors and tenants are favoured over those of creditors and landlords. Hyperinflation therefore is not just a run from a currency, but from the economic system entirely. Thousands of years of Diaspora are screaming to us in the face that the advantage of gold as an easy-to-transport and store asset is not to be underestimated.
Why have we not seen a quasi-fiscal deficit yet and how close are we too see one?

I think that at this point one can easily see how high nominal interest rates (to attract deposits) and hyperinflation go together. The loss of confidence in the system pushes nominal rates higher, which causes even more pain to produce, unleashing shortages of goods and higher prices. Von Mises, for instance, remembered that in the case of the German hyperinflation, “…With a (my note: nominal) 900 per cent interest rate in September 1923 the Reichsbank was practically giving money away…” (Chapter 7, in “Money, Method, and the Market Process”).

Frankly, I do not have a definitive answer to the question of why we have not seen a quasi-fiscal deficit yet. But I can intuit that we are still far from seeing one. There are many factors at play. The existence of coercive pension plans (i.e. monies coercively taken from salaries to fund collective distributions) could be playing an important role. These funds are “other peoples’ monies” to their managers and they will not risk their careers to protect them from governments that force them to assign a zero risk weight to US Treasury holdings. It is conceivable that as funds are burdened with losses, the contributors wake up to them and decide that at a certain point, one is better off working outside the system than in it, to avoid this hidden tax. Just like Romans left the city, millions of workers in the developed world may decide to become self-employed and leave the system. This is a typical characteristic of under-developed economies.

So far, the Federal Reserve does not even need to sterilize what it prints. The European Central Bank did have to sterilize but the market does not demand an interest rate on its liabilities, higher than that of the sovereign debt it purchases. Not yet…Perhaps because the market somehow still believes that institutional structure of the European Monetary Union is fixable. Further downgrades in the risk rating of core Europe, the concurrent rise in the yields ofGermany’s sovereign debt and corporate defaults in USD denominated bonds will eventually wipe this belief. For now, the European Central Bank has been successful in not even having to pay interest on deposits.

If I have to think of a main and most likely trigger of quasi-fiscal deficits, I have to name the future bailout of the next wave in corporate defaults, particularly from the Euro zone.


George Dorgan
George Dorgan (penname) predicted the end of the EUR/CHF peg at the CFA Society and at many occasions on SeekingAlpha.com and on this blog. Several Swiss and international financial advisors support the site. These firms aim to deliver independent advice from the often misleading mainstream of banks and asset managers. George is FinTech entrepreneur, financial author and alternative economist. He speak seven languages fluently.
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